Roth Conversion and the Pro-Rata Rule

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I received the following question from a reader. It’s a unique situation that you may find interesting, so I thought I’d share the interaction with you:

Here’s my situation, this year I started with the following:

(A) Rollover IRA (from rollover funds several years ago with no new funds added since. $157K was rolled over in 2020, but account is now valued at ~$146K).
(B) Roth IRA (that was opened years ago with minimal amount, but no new funds added in the past decade due to income limitation).
(C) Non-deductible (separate) traditional IRA account opened in 2016 with contributions deposited in each year, but have only been depositing NON-DEDUCTIBLE dollars (a total of $23K invested). However, the account was only worth ~$17K/$18K at the time I went to convert).

In early 2022, after making the 2022 contributions, I converted the entire value of the non-deductible traditional IRA account to a Roth IRA.

My question is: since I’ve kept my non-deductible contributions in a separate account and converted to the Roth IRA, am I subjected to the pro-rata rule for taxes due for 2022 even though I have no other IRA account other than the Rollover IRA? I had thought that since I had a “loss” with my non-deductible account, and that I kept the funds separate, I would not, but not sure.

This was my response:

It seems like this could be pretty complex, but it really isn’t too bad if you keep two things in mind (and unfortunately it’s not going to work out like you hoped):

1) the IRS looks at all of your traditional IRAs (includes rollovers, deductible contributory and non-deductible contributory) as one single balance.

2) given #1, you cannot separate deductible and non-deductible amounts when taking distributions.

Since a Roth conversion is a distribution, and knowing what we know from #1 & #2 above, part of your conversion would be taxed and part of it would be tax-free – and the amounts would be pro-rated, based upon a calculation factoring your end-of-year balances in all of your IRA accounts, plus any amount that was distributed during the year.

So, if you take the balance of your first IRA at the end of this year (we’ll assume it’s still $146k) and add the amount of your non-deductible IRA (again we’ll assume $18k), you come up with a total of $164k (also assuming there are no other distributions this year). Of that, you indicated that there was $23k from non-deductible contributions. Dividing that non-deducted amount by the total we come up with ~14.02% (23k / 164k = .14024). Of the $18k that you converted, 14.02% or $2,523.60 would be considered tax-free distribution, and the remaining $15,476.40 would be taxable. (This calculation was done with the very round figures that you provided. Actual end-of-year 2022 figures must be used to calculate the true pro-rata amounts.)

And then there was a follow-up from the reader:

Just a few additional follow-up questions for you:

(1) If only a percentage of my distribution is tax-exempt this year, am I not being “double-taxed” (so-to-speak) on the $15,476.40, since this is after-tax dollars that funded the non-deductible traditional IRA? If I make NO additional conversions or distribution until I reach of age, 59 1/2 (by the way, I’m currently married and in my mid-forties), what amount is tax-exempt when I make the next distributions? Can I expect $15,476.40 ($18K – $2,523.60)  + $15,476.40 (taxes due this year) = $30,952.80 now considered as non-deductible because taxes have already been paid (50% was non-deductible conversion, the other 50%, taxes paid in 2022)? Assuming NO new non-deductible funds moving forward, is my “new” non-deductible amount now stand at $30,952.80?

(2) Since my current Roth IRA is UNDER $30,952.80, how can I now correctly earmarked my Rollover account with taxes already paid to $15K so that when it’s time for me to take distribution from that account, I’m not going to be taxed again (!)? In other word, for argument sake, let’s just say my Rollover IRA does not grow beyond $146K until I’m 59 1/2, can I then use $15,476.40 as non-deductible dollars of my $146K, thereby, only ~$130K is taxable? Additionally, I would assume that my Roth would now grow tax-free from here-on-in, so any gains is not subjected to taxes.

(3)  Finally, is there any way that I can undo what was converted to my Roth IRA in 2022 before I file my taxes on April 15? I did the non-deductible to Roth IRA conversion back in Jan 2022. I did A LOT of research and there was a lot of advice that stated that if one had non-deductible funds in a separate traditional IRA, that one would be able to make a Roth conversion TAX-FREE. It was touted as a way for those of us who had not been able to make Roth IRA conversions because of income limits to now be able to take advantage of the Roth. There was not any mention of the Pro-Rata. It appears that somewhere recently, the pro-rata rule came into play, and now those conversions are not only NOT tax-free, but potentially can be double-taxed! I can’t quite understand how this can be done so that I’m not being double-taxed on my non-deductible funds.

… and here is my response to the follow-up:

Back to my #1 and #2 – you had total basis of $23k (the non-deductible amount) in all of your traditional IRAs. With the distribution and the pro-rata taxation, you will have used up $2,523.60 of the $23k. As you distribute funds from your IRA, each year the rate will adjust to match the new figures. YOU MUST KEEP TRACK OF YOUR BASIS ON YOUR OWN – no one else will track this for you, unless you have your tax guy do it and then I’d keep my own record anyhow if I were you.

In other words, as long as you maintain your records and mark your future distributions as pro-rata partly taxed and partly non-taxed to the extent of the remaining ~$15k, there is no double-taxation going on.

The amount in your Roth account is not considered non-taxable basis for your Traditional IRA. The balance of your Roth IRA is classified as:  amounts you’ve contributed, amounts you’ve converted, and growth on the value of the first two amounts. The only figure in the Roth account that’s important to track is the total of the amount you contributed or converted, since if you begin taking distributions before age 59½ you’ll need to know how much has already been taxed. Early distributions from the Roth account are not subject to a pro-rata rule – your taxed contributions come out first, then conversions, and then growth last. If it’s been more than 5 years since conversion, those amounts can be penalty free as well.

Unfortunately there is no longer the ability to “undo” the Roth conversion. This was eliminated a few years ago, so you’re stuck with your conversion as-is.

After my response, the reader replied:

Can I roll all the deductible portion, $130K of my Rollover IRA (i.e. $146K – ~$16K = $130K) to my current Employer’s 401K, and then convert the $16K tax-free to my Roth IRA this year since I would have paid taxes on this? Tracking the non-deductible versus deductible seems too complicated — can I just do it this way? That way, outside of the company’s 401K plan, after it’s all said and done I’d only have a Roth IRA and zero balance in a non-deductible IRA?

To which I responded as follows:

Yes, such a move would work. This would be one way of getting around the problem with your future conversion/taxation – rollover the monies from the deductible account (except for the remaining non-deducted basis) to your 401(k), and then convert the non-deducted remainder to Roth. The biggest problem with this is getting the 401(k) plan to accept the roll-in of your IRA, which isn’t a big deal for most plans.